Individual Assignment 6 - Tesla Stock Compensation

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Apr 3, 2024

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Interpreting Financial Statements (ACCTG 5610) Individual Assignment 6 – Tesla: Stock Options (10 Points) Learning Objectives The purpose of this assignment is to ensure the student is able to: • Locate and interpret a stock compensation note. • Understand the assumptions used in the Black-Scholes-Merton option pricing model. • Consider the impact of stock compensation on motives/opportunities for financial statement manipulation. • Understand the strengths and weakness of accounting for stock-based compensation. • Critically think through current issues regarding stock-based compensation plans offered by public companies. Tesla, Inc. (“Tesla”), ticker: TSLA , has robust stock-based compensation plans which have recently made headlines. The following questions pertain to Tesla’s financial statements for the year ended December 31, 2023 (although you will also need to reference the 2018 10-K filing for question 5). 1. What types of stock-based compensation does the company offer? Briefly describe the different types of awards that are offered to company employees. (1 point) Tesla offers service and/or performance-based, stock compensation, of which, restricted stock, employee stock purchase plans, employee incentive stock options, and nonstatutory stock option are available as equity awards. The restricted stocks are recognized over the required service time the employee who possesses them works, whereas the employee stock purchase plans and stock options, are based off of services provided to Tesla and service time. 2. How does Tesla estimate the risk-free rate, expected option life, and volatility for use in the Black- Scholes option pricing model? On a scale of 1 (little), 2 (some) or 3 (a lot), how much managerial judgement is employed in making estimates such as these? Why might this be a concern? (2 points) Tesla estimates the risk-free rate, “based on the U.S. Treasury yield for zero-coupon U.S. Treasury notes with maturities approximating each grant’s expected life.” Said expected life is estimated from historical data, with “generally four years for stock options and RSUs and six months for the ESPP.” Finally, “volatility is based on the average of the implied volatility of publicly traded options for [Tesla’s] common stock” and said common stocks’ historical volatility. I would rate managerial judgement as a 1 because the risk-free rate has a direct location, however, expected life and volatility are based on historical data and assumptions. Companies would rather take less expenses from stock options, encouraging taking liberties with such “expected changes” to minimize costs. 3. Using the option pricing worksheet posted on Canvas and Tesla’s assumptions, estimate the Black- Scholes weighted average fair value per share for the options granted in fiscal 2023. What is Tesla’s estimate? How does your estimate compare? (Please include a screenshot of your spreadsheet) (1 point) Tesla’s weighted average fair value per share for the options granted in fiscal 2023 was $121.62. My result was $194.38. I believe, unlike we saw with Zillow, that Tesla only providing one number under votality and expected life option is a reflections as to why amounts could be so different, based on the historical amounts for “expected changes.” A almost 1.6 increase from the 10-K amount to my demonstrates the limitations of estimatuons due to chaging volatilites, rates, etc.

4. Assume that the options that Tesla granted in fiscal 2023 are exercised at some future date when Tesla’s stock is worth $450 per share. Under grant-date accounting , what is the cumulative amount of expense that Tesla would charge against income for these options ( hint: use the estimated weighted-average fair value per share for 2023 from the 10-K --- note: this is the number that you compared your calculation against in the previous question )? Under exercise- date accounting, what is the cumulative amount of expense that Tesla would charge against income for these options? Which of these (grant date or exercise date accounting) is required by US GAAP? Which provides a more representationally faithful estimate of the amount of wealth transferred from existing shareholders to employees? Ignore related tax benefits. (2 points) Cumulative Expense = Grant Date Fair Value * Number of Options Granted 121.60 * 9,521,000 = $1,157,753,600 Cumulative Expense = (Market Price of the Stock at Exercise Date - the Exercise Price of the Option AKA Intrinsic Value) * the Number of Options Granted (100 – 226.50) * 9,521,000 = $1,204,406,500 Grant date is required by US GAAP, but settlement date provides a more representationally faithful estimate of the amount of wealth transferred from existing shareholders to employees because grant dates are easier to manipulate, require disclosures, and are not “trued up.” 5. In accordance with US GAAP, stock-based compensation expense is recognized over the longer of the expected achievement period for performance/operational milestones, beginning at the point in time when the relevant milestone is considered probable of being met. Now, refer to the 2018 Tesla 10-K (filed on 2/19/19). This filing provides a detailed discussion of the 2018 CEO Performance Award that was granted to Elon Musk. According to Note 15, what performance and market conditions are required in order for the compensation package to vest? Which of these conditions did management believe were probable of achievement as of December 31, 2018? As a

result, how much stock compensation expense was recorded related to the 2018 CEO Performance Award in 2018? (3 points) Both conditions were reliant on Elon Musk remaining “either as the CEO or as both Executive Chairman and Chief Product Officer and service through each vesting date.” The performance and market conditions for him were that market capitalization would increase to $100 billion to start, and then in $50 million increments. Additionally, revenue and Adjusted EBITDA accounts would have reach predetermined, increasing targets. If all these conditions were not continuously met, Musk would not be able to fully vest. As of December 31, 2018, management believed “$598.0 million of total unrecognized stock-based compensation expense for the operational milestones… were considered probable of achievement.” This amount included the probability of $20 billion in total revenue, Adjusted EBITDA of $1.5 billion, and Adjusted EBITDA of $3.0 billion being reached. “Stock- based compensation expense of $174.9 million relat[ing] to the 2018 CEO Performance Award” was recorded in 2018. 6. Read the following article (source: https://www.wsj.com/business/elon-musks-55-billion-tesla- pay-package-struck-down-by-judge-3e619f53?page=2 ) Opinion Question: The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, allows shareholders to approve the compensation of executive officers. The vote of the shareholders is non-binding, but advisory to the company’s compensation committee. The 2018 Proxy Filing stated the following regarding shareholder approval of the 2018 CEO Performance Award, “On March 21, 2018, such approval was obtained, with approximately 73% of the votes cast by such disinterested shares voting in favor of the 2018 CEO Performance Award.” However, there was one shareholder (this individual held only 9 shares of Tesla’s stock) that filed a lawsuit regarding Musk’s compensation package. The suit eventually went to trial and earlier this month a Delaware judge struck down the 2018 compensation package. Read the article below and comment on the following: if you were a Tesla shareholder in 2018, how would you have voted on the compensation package for Elon Musk? (1 point) Hindsight is 20/20 so I think everyone would like to believe they would be one of the shareholders to vote against the compensation package, but honestly, I bet I would have been one of the disinterested shareholders who would assume my vote wouldn’t really matter anyway. Seeing one individual with so little shares take an interest and be able to hold the power to change a billionaire’s fate does give a representation of the power of accessible financial statements. Back in 2018, if I were to vote no, it would be less about the financial aspect of everything and more about how creepy I find Musk to be and my disapproval of one individual having so much financial backing. I would like to think that if I were a shareholder in 2018, I would assume, because of the stakes he already had in the company, his reputation, and the growth of Tesla, that the compensation package to motivate Musk, wouldn’t be necessary. I believe he would meet those goals simply to help expand his brand recognition and begin other start-ups as he so passionately does. For these reasons I would hope that I would have voted no and once again I should never overlook the notes to the financial statements in my future endeavors.

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